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What do we study in Economics? What do we study in Finance? And why?

What do we study in Economics? What do we study in Finance? And why?. In Economics we describe the decision of individuals as “laws of nature” in the hope of understanding different economic outcomes (inflation, unemployment, growth of the economy).

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What do we study in Economics? What do we study in Finance? And why?

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  1. What do we study in Economics?What do we study in Finance? And why? • In Economics we describe the decision of individuals as “laws of nature” in the hope of understanding different economic outcomes (inflation, unemployment, growth of the economy). • The ultimate objective is typically to “maximize growth” (or more explicitly, growth per capita). But why? Is growth of the economy the most important thing for human beings?

  2. Question? • Is Growth Really important? Suppose I gave you a choice of either receiving $1 million today, or alternatively, I would transfer you to 1900 (with all your friends and family) and gave you this same amount of $1 million in 1900?

  3. What can you buy for $1 million in Vancouver? 1900 2015

  4. Where would you rather live?

  5. What is Finance about, and how it is related to the objective of Economics? • It is hard to make decisions based on “happiness”, because it is not a well defined term. It is not at all clear that people today are happier than in 1900. Nevertheless, maximization of growth seems to be a relatively unifying idea, and overall, people in wealthier countries seem to have a more comfortable life. • Finance is inherently related to the “growth” objective, but it focuses on two main aspects: • How to price assets, using no arbitrage – without a pricing mechanism that represent “worth” – we end up with inefficient outcomes. • How firms should make decisions – using the idea that they must be efficient, and make society better off.

  6. Chapter 1 The Corporation

  7. The History of Economics Adam Smith Karl Marx 1723-1790 Scottish Philosopher • Private ownership • Competitive markets make for efficiency • Freedom 1818-1883 German Philosopher • Government ownership • Competition makes workers worse off • Freedom

  8. Famous quotes: • Adam Smith “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest” • Karl Marx “The theory of Communism may be summed up in one sentence: Abolish all private property”

  9. A few basic questions • Why is finance such a “new” science (became a science in 1964)? • Why was insurance only developed in 1680? • Why was growth basically zero till the 19th century?

  10. 1.1 The Main Types of Firms • Sole Proprietorships • Partnerships • Limited Liability Companies (One of the greatest inventions) • Tax implications of a corporation

  11. Figure 1.1 Types of U.S. Firms Source: www.bizstats.com

  12. Worldwide Stock Markets Ranked by Two Common Measures The 10 biggest stock markets in the world ranked (a) by total value of all domestic corporations listed on the exchange at year-end 2004 and (b) by total volume of shares traded on exchange in 2004. Source: www.world-exchanges.org

  13. Understanding Capitalism • The Corporate Management Team – what is its objective and is it fair? • The role of the market

  14. Understanding Capitalism The Inherent Problems of the Capitalistic System -The Principal-Agent Problem • What mechanisms can help? • Takeover market • Board of directors • Compensation • Shareholder Activism and Voting Rights • Corporate governance (SEC – securities and exchange commission)

  15. Chapter 2 Introduction to Financial Statement Analysis

  16. Chapter Outline 2.1 Firms’ Disclosure of Financial Information 2.2 The Balance Sheet 2.3 Balance Sheet Analysis 2.4 The Income Statement 2.5 Income Statement Analysis 2.6 The Statement of Cash Flows 2.7 Other Financial Statement Information 2.8 Financial Reporting in Practice

  17. Table 2.1 Global Conglomerate Corporation Balance Sheet for 2009 and 2008

  18. Equation 2.2

  19. Equation 2.3

  20. Equation 2.4

  21. Table 2.2 Global Conglomerate Corporation Income Statement Sheet for 2009 and 2008

  22. Equation 2.5

  23. Equation 2.8

  24. Equation 2.10

  25. Equation 2.12

  26. 2.6 Accounting versus Finance • Past versus future • Timing of cash flow versus matching principle • However, are very much related and one needs both to understand the firm

  27. Chapter 3 Arbitrage and Financial Decision Making

  28. Chapter Outline 3.1 Valuing Decisions 3.2 Interest Rates and the Time Value of Money 3.3 Present Value and the NPV Decision Rule 3.4 Arbitrage and the Law of One Price 3.5 No-Arbitrage and Security Prices

  29. Chapter 3, Q1 Valuing Decisions Honda Motor Company is considering offering a $2000 rebate on its minivan, lowering the vehicle’s price from $30,000 to $28,000. The marketing group estimates that this rebate will increase sales over the next year from 40,000 to 55,000 vehicles. Suppose Honda’s profit margin with the rebate is $6000 per vehicle. If the change in sales is the only consequence of this decision, what are its costs and benefits? Is it a good idea?

  30. Chapter 3, Q4: Calculating Cash Values Using Market Prices • Suppose your employer offers you a choice between a $5000 bonus and 100 shares of the company stock. Whichever one you choose will be awarded today. The stock is currently trading for $63 per share. • Suppose that if you receive the stock bonus, you are free to trade it. Which form of the bonus should you choose? What is its value. • Suppose that if you receive the stock bonus, you are required to hold it for at least one year. What can you say about the value of the sock bonus now? What will your decision depend on?

  31. Example: When Value Depends on Preferences

  32. Comparing Costs at Different Points in Time

  33. Figure 3.1 Converting Between Dollars Today and Gold, Euros, or Dollars in the Future We can convert dollars today to different goods, currencies, or points in time by using the competitive market price, exchange rate, or interest rate.

  34. Example: The NPV Is Equivalent to Cash Today

  35. 3.4 Arbitrage and the Law of One Price • An Old Joke • Can we have a case in which Gold is traded at a different price on NYSE and LSE? • Law of One Price – Prevails or else we would have an arbitrage opportunity.

  36. Example 3.6: Computing the No-Arbitrage Price

  37. Three Profound Ideas The NPV of trading securities The Separation principal Value additivity

  38. Cash Flows and Market Prices (in $) of a Risk-Free Bond and an Investment in the Market Portfolio

  39. Determining the Market Price of Security A (cash flows in $)

  40. A Negative Risk Premium

  41. Risk and Risk Premiums for Different Securities

  42. The No-Arbitrage Price Range

  43. Extra homework question (not to submit) Given the above information find the price of each state, the risk free rate, and the price of security W.

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